Current volatility indicators and metrics clearly outline the fragility of financial markets at the moment.
Financial stocks remain weak due to further write-down concerns, earnings weakness as well as capital pressure. However, traders are beginning to focus on resource and commodity prices, specifically the worry that the commodities super-boom may have peaked and could be over. Resource stocks have been hit over the last few trading days in world markets following a 13 per cent fall in US coal shares and 12 per cent decline in steel stocks. Further declines in blue chip resource stocks in the US would reverberate to other resource-led markets such as Australia.
Markets remain worried that if prices in steel, oil, coal and base metals begin to weaken, then further sharp falls across all equities will be unavoidable. Resource stocks, particularly oil and base metals, have been the one positive area with traders buying resources while shorting financials, industrials and housing and construction firms. Rising inflation in Asia in particular and falling demand in the West do not bode well for demand for resources going forward.
In particular to steel makers and coal producers, any further signs that support the view that economies will face a noted and prolonged downturn, will be felt immediately in share prices. Oil continues to hit record levels, however, as dollar weakness and underlying strength in demand pushes the price of a barrel to new heights. The oil price recently breached $146 per barrel, the highest price since trading commenced in 1983. Despite a small segment of the market suggesting that an oil price bubble has been created, current supply constraints make a significantly weaker price unlikely at present or in the short term. The higher probability and risk remains in the price scaling new heights.
In turn, the escalating oil price is driving inflation rates higher globally. As a result, economies and companies face further pressure. Unemployment is rising in many western markets. The US payrolls fell by 62,000 in June following a similar fall the previous month. The US inflation is moving towards five per cent and the slowdown is going to be more protracted than previously expected.
The Dow Jones Industrial average extended its decline from the October record to more than the 20 per cent, and the gauge has closed below the threshold that signals a so-called bear market. The broader based S&P 500 is also showing a significant fall. The credit crisis triggered by the US sub-prime mortgage collapse has erased one quarter of the banking industry's value. Many believe the bottom has not been reached with further write-downs to come. Global write-downs now total $400bn (Dh1,459bn) with capital raising exercises amounting to $320bn.
Banks are continuing to raise equity capital, which is closely correlated with falls in asset valuations. There is no let up in the fall in US house prices and foreclosures continue to amount. The weakness in the US housing market is also gaining momentum. The Euro zone is now facing growth pressure and the most recent rise in Euro interest rates will exacerbate the situation.
Dollar-denominated debt has been traded off over the last month, with short-term correlations to US treasuries becoming positive. This is due to renewed concerns about credit risk, particularly inflation. Emerging economies will slow as monetary policies are tightened. As some central banks in the emerging markets are behind the curve, the process may be more prolonged resulting in greater costs to the economy.
From an investment viewpoint, the lack of consistency in approach may provide opportunities to buy into dips. India has raised rates by a further 50 basis points and other emerging markets have also raised rates. Russia is contemplating increasing the rouble band, which will lead to an appreciation. Consumer demand rose by 14.6 per cent and wages by 31.8 per cent year on year in May in Russia. South African inflation is much higher than expected, at 16.4 per cent against 12.4 per cent expected year on year. Egypt also faces inflationary challenges with its rate at 20 per cent. Inflation is a key risk for real growth in the GCC.
Worldwide economic growth will contract next year. The extent of the decline will have an acute bearing on corporate earnings and stock prices as a result. Prices and indices will be volatile, providing both opportunities and pitfalls.